Greece’s debt crisis explained

A demonstrator shouts slogans as she holds a placard reading ‘YES to Greece, Yes to Euro’ during a rally organized by supporters of the YES vote to the upcoming referendum in front of the Greek Parliament in Athens, Tuesday, June 30, 2015. | (AP/Petros Karadjias)

The Greece debt crisis is more than whether the tiny country of Greece defaults on its debt or leaves the eurozone. Like the 2008 collapse of a small investment bank called Lehman Brothers, some think a Greek default could plunge the world into a financial crisis. The Greek debt crisis, like the historical canary in a coal mine, warns of the danger facing other heavily indebted countries.Six years after its inception, European Union (EU) leaders still struggle to agree on a resolution.

Latest Developments:Eurozone sets Sunday deadline
July 7: Frustrated European leaders gave Greece until Sunday to reach an agreement to save its collapsing economy from catastrophe after an emergency summit meeting here on Tuesday ended without the Athens government offering a substantive new proposal to resolve its debt crisis.

Deadlines have come and gone without serious consequences, but yet another emergency gathering, this one involving all 28 European Union leaders in Brussels on Sunday, might really be a crunch point. “This could be the last meeting about Greece,” Prime Minister Matteo Renzi of Italy told reporters on Tuesday night.

The German chancellor, Angela Merkel said the leaders of all European Union member states would attend the meeting on Sunday because any decision would affect future members of the single currency. The presence of leaders from the full bloc could also be needed to approve European Union humanitarian aid for Greece in case a bailout deal for the country remains out of reach.

Greek banks remain closed this week, because they need additional euros from the ECB before reopening. ATM withdrawals are now effectively restricted to €50 per day, since the banks have run out of smaller denominations. Banks only had €1 billion in cash as of July 4, and some are rumored to be teetering on the edge of bankruptcy. If a deal is reached, banks may need as much as €10 billion in cash just to stay in business.

The closure of Greek banks threatens the tourist industry, as the 14 million tourists who visit the country this time of year may decide to go elsewhere if they can’t use the local banks. In addition, Greece imports 40% its food and pharmaceuticals and 80% of its energy. Many companies are questioning whether they will export these items to a country that may not be able to pay its bills.

The Greek Finance Minister, Yanis Varoufakis, has been replaced by the less abrasive Euclid Tsakalotos, who is expected to submit a bailout proposal that the EU can live with. Most likely, it will ask for debt reduction that is actually an extension of repayment terms.

Whether it includes the pension reforms and tax increases that the EU insisted upon is unlikely, since the Greek people voted against these austerity measures on July 5, 2015.

What happens next?
That’s the billion-euro question.
Greek citizens decidedly rejected the terms of an international bailout in a referendum over the weekend. The Greek government’s victory in the referendum, however, settled little, since the creditors’ offer was technically no longer on the table.

The next major deadline is in late July, when a 3.5 billion euro payment that Greece owes the European Central Bank comes due. The E.C.B. on Monday said it would continue to make 89 billion euros, or about $98.4 billion, in emergency loans available to Greek banks. It is enough to keep the banks from failing but not enough to prevent them from running out of cash that they can issue to depositors within a few days.

If there is no international bailout program in place by the July deadline, and little chance of such a program being in the works, the central bank at that point would probably have to finally take Greek banks off life support.

Did Greece default on its debt?
When borrowers — whether they are countries, companies or individuals — do not pay their debts on time, they are in default. For practical purposes, then, Greece — which on Tuesday failed to make a scheduled debt repayment of about 1.5 billion euros, or $1.7 billion, to the International Monetary Fund — has defaulted.

The I.M.F., however, does not use the term default. It instead places countries that miss their payments in what it calls arrears.
Semantics aside, missing the payment might lead to a situation in which other large Greek debts are classified as being in default.

If a deal isn’t reached by July 20, Greece must leave the eurozone, known informally as a Grexit. That’s when loan payments to the ECB itself are due. If Greek banks default, the ECB cannot lend them any more funds. However, most analysts agree the ECB will “cut the cord” much sooner than that.

How it started?
In 2009, Greece kicked off the crisis by admitting its budget deficit would be 12.9% of GDP (Gross Domestic Product). That’s more than four times the EU’s 3% limit. Ratings agencies Fitch, Moody’s, and Standard & Poor’s scared off investors by lowering Greece’s credit ratings. Unfortunately, it also drove up the cost of future loans, making it more unlikely that Greece could find the funds to repay its sovereign debt.

In 2010, Greece announced an austerity package that would lower the deficit to 3% of GDP in two years. It was designed to reassure the agencies it was fiscally responsible. Just four months later, Greece warned it might default anyway.

The EU and the IMF provided €240 billion in emergency funds In return for even more austerity measures. That only gave Greece enough money to pay interest on its existing debt and keep banks capitalized and barely running. Unfortunately, the measures further slowed the Greek economy, reducing the tax revenues needed to repay the debt. Unemployment rose to 25%, riots erupted in the streets, and the political system was in an upheaval as voters turned to anyone who promised a painless way out.

In 2011, the European Financial Stability Facility (EFSF), another lending facility funded by EU countries, adds €190 billion to the bailout.

By 2012, Greece’s debt-to-GDP ratio had risen to 175%, nearly three times the EU’s limit of 60%. Bondholders finally agreed to a haircut, exchanging $77 billion in bonds for debt worth 75% less.

What if Greece leaves the Eurozone?
If there is no further bailouts from the EU, Greece will have to abandon the euro, and reinstate the drachma. That ends the hated austerity measures, allowing the Greek government to hire new workers, reduce the 25% unemployment rate, and boost economic growth. It would convert its euro-based debt to drachmas, print more currency, and lower its exchange rate versus the euro. This reduce its debt, lowers the cost of exports, and attract tourists to a lower-cost vacation destination.

That might initially seem great for Greece, but foreign owners of Greek debt would suffer debilitating losses as the drachma plummeted, debasing the value of repayments in their own currency. Some banks may even go bankrupt. However, most of the debt is owned by European governments, whose taxpayers would be left footing the bill.

Plummeting drachma values could trigger hyperinflation, as the cost of imports skyrocket. The country would have a hard time attracting new foreign direct investment in such an unstable situation. The only countries that have signaled they would lend to Greece are Russia and China. Eventually, Greece would find itself back to where it is now–burdened under debt it can’t repay.

Interest rates on other indebted countries might go higher as ratings agencies become concerned they’d leave the euro also. The value of the euro itself might weaken as currency traders use the crisis as a reason to bet against it.

What happens if Greece defaults?
A widespread Greek default would have a more immediate effect. First, Greek banks — already on the brink — would go bankrupt without loans from the ECB. Losses could threaten the solvency of other European banks, particularly in Germany and France. They, along with other private investors, hold €34.1 billion in Greek debt.

In addition, eurozone governments own €52.9 billion. That’s in addition to the €131 billion owned by the EFSF (in other words, eurozone governments). Some countries, like Germany, won’t be affected by a bailout. Even though Germany owns the most debt, it is a tiny percentage of its GDP, and much of the debt doesn’t come due until 2020 or later. Smaller countries face a graver situation; Finland’s portion of the debt is 10% of its annual budget. (Source: Finland Lays Out What’s At Stake With Greece, AP, July 7, 2015)
The EU’s central bank (ECB) holds €26.9 billion of Greek debt. If Greece defaults, it won’t put the future of the ECB at risk. That’s because it’s highly unlikely that other indebted countries would decide to default.

How does the crisis affect the global financial system?
In the European Union, most real decision-making power, particularly on matters involving politically delicate things like money and migrants, rests with 28 national governments, each one beholden to its voters and taxpayers. This tension has grown only more acute since the January 1999 introduction of the euro, which now binds 19 nations into a single currency zone watched over by the European Central Bank but leaves budget and tax policy in the hands of each country, an arrangement that some economists believe was doomed from the start.

Since Greece’s debt crisis began in 2010, most international banks and foreign investors have sold their Greek bonds and other holdings, so they are no longer vulnerable to what happens in Greece. (Some private investors who subsequently plowed back into Greek bonds, betting on a comeback, regret that decision.)
And in the meantime, the other crisis countries in the eurozone, like Portugal, Ireland and Spain, have taken steps to overhaul their economies and are much less vulnerable to market contagion than they were a few years ago.

How likely is there to be a ‘Grexit’?At the height of the debt crisis a few years ago, many experts worried that Greece’s problems would spill over to the rest of the world. If Greece defaulted on its debt and exited the eurozone, they argued, it might create global financial shocks bigger than the collapse of Lehman Brothers did.

Now, however, some people believe that if Greece were to leave the currency union, in what is known as a “Grexit,” it wouldn’t be such a catastrophe.

Europe has put up safeguards to limit the so-called financial contagion, in an effort to keep the problems from spreading to other countries. Greece, just a tiny part of the eurozone economy, could regain financial autonomy by leaving, these people contend — and the eurozone would actually be better off without a country that seems to constantly need its neighbors’ support.

Others say that’s too simplistic a view. Despite the frustration of endless negotiations, European political leaders see a united Europe as an imperative.

At the same time, they still haven’t fixed some of the biggest shortcomings of the eurozone’s structure by creating a more federal-style system of transferring money as needed among members — the way the United States does among its various states.

Exiting the euro currency union and the European Union would also involve a legal minefield that no country has yet ventured to cross. There are also no provisions for departure, voluntary or forced, from the euro currency union.

Why are austerity measures needed?
Long-term, the measures will improve Greece’s comparative advantage in the global marketplace. The austerity measures required Greece to improve how it managed its public finances and its financial statistics and reporting. It also reformed its labor market and pension system, and lowered trade barriers. Initially, exports began to rise.

The OECD recommended Greece raise more revenue by strengthening tax collection, taking a hard line against tax evasion, and selling off state-owned businesses and assets. However, this is exactly what the Greeks did not want to do. Instead, they periodically threaten to default on their debt and leave the eurozone if the EU continued to increase austerity.

Germany and other EU leaders, as well as bond ratings agencies, wanted to make sure Greece wouldn’t just take on new debt to pay off the old. Germany, Poland, Czech Republic, Portugal, Ireland, and Spain had successfully used austerity measures to strengthen their own economies. Since they were paying for the bailouts, they wanted Greece to follow their examples.

Causes of the Greece crisis
How did Greece and the EU get into this mess in the first place? The seeds were sown back in 2001, when Greece adopted the euro as its currency. Greece had been an EU member since 1981, but its annual budget deficit was never low enough to satisfy the eurozone’s Maastricht Criteria.

All went well for the first several years. Like other eurozone countries, Greece benefited from the power of the euro, which meant lower interest rates and an inflow of investment capital and loans.

However, in 2004, Greece announced it had lied to get around the Maastrict Criteria. Surprisingly, the EU imposed no sanctions! Why not? There were three reasons.

France and Germany were also spending above the limit at the time. They’d be hypocritical to sanction Greece until they imposed their own austerity measures first.

There was uncertainty on exactly what sanctions to apply. They could expel Greece, but that would be highly disruptive and possibly weaken the euro itself.

The EU wanted to strengthen, not weaken, the power of the euro in international currency markets. A strong euro would convince other EU countries, like the UK, Denmark, and Sweden, to adopt the euro. (Source: Bloomberg, Greece Cheated, May 26, 2011; BBC News, Greece Joins Eurozone, January 1, 2001; Greece to Join Euro, June 1, 2000).

As a result, Greek debt continued to rise until the crisis erupted in 2009. Now, the EU must stand behind its member or face the consequences of either Greece leaving the eurozone, or even worse, a Greek default.

Amid concerns about the fiscal picture in Greece, European leaders held a meeting in Brussels on Tuesday, ahead of an emergency Euro Summit